Published by EH.NET (August 2007)

Bernard C. Beaudreau, How the Republicans Caused the Stock Market Crash of 1929: GPT’s, Failed Transitions, and Commercial Policy. Lincoln, NE: iUniverse, 2005. xx + 200 pp. $19 (paperback), ISBN: 0-595-37908-7.

Reviewed for EH.NET by Carlos D. Ramirez, Department of Economics, George Mason University.

In his book, Bernard C. Beaudreau (Professor of Economics at Universite Laval, Quebec City, Canada) “presents an alternative view of the Stock Market Boom and Crash of 1929 as having resulted from government intervention, specifically from a case of flawed government policy in the form of the Republican Party’s 1928 election promise of an upward tariff revision ? the Smoot-Hawley Tariff Bill” (p. xi). He claims that the tariff aggravated the problem of “underincome” (which he defines as the failure of aggregate income and expenditures to rise commensurately with productive capacity), thereby amplifying the extent of the Depression.

The logic of his argument is as follows: The technological progress of the 1910s and 1920s, manifested by the increasing adoption of electricity-based, mass production processes (coined in the book as “extremely-high-throughput, continuous-flow mass production techniques,” or EHTCFPT), resulted in a phenomenal increase in industrial productive capacity throughout the 1920s. But this increase in capacity was not accompanied by an increase in wages, and thus expenditures did not increase commensurately. Beaudreau argues that the government’s first response to resolve the problem of “underincome” was to resort to tariff protection (e.g. the Smoot-Hawley Act). By protecting domestic markets, the tariff would increase sales, employment, and earnings. In fact, Beaudreau argues that initially the stock market reacted positively to the tariff as investors were anticipating future higher sales. He even points out that the stock market crashed in October of 1929 as a result of bad news regarding the implementation of the tariff ? by October of 1929 it was presumably apparent that the tariff bill would not be enacted as a coalition of “Insurgent Republicans” and Democrats called for lower tariffs on manufactures. By December of that year, he continues, the tariff was no longer being perceived as being “good news” as investors this time were anticipating retaliatory tariffs from trading partners. Thus, when the tariff finally made it into law in 1930, the stock market reaction was largely negative. According to the logic of the argument, then, before December of 1929, the tariff bill was perceived to be “good news” by investors. After December, however, it was perceived to be “bad.” Besides, he argues, the tariff aggravated the problem of “underincome” because it further stimulated firms to adopt EHTCFPT, as they wanted to increase their production capacity in anticipation of future higher demand.

After realizing the failure of the tariff to resolve the problem of “underincome,” Beaudreau argues, the government resorted to the National Industrial Recovery Act of 1933 as a second response. However, this response also ultimately failed to completely resolve the “underincome” problem. In the end, Beaudreau returns to the tariff issue and argues that it was an ill-conceived policy idea since according to his estimates the output gap was too large to be resolved by the tariff alone.

The argument is laid out in eight chapters. Chapter 1 presents an overview of the history of U.S. tariff policy (and even tariff theory) from the antebellum period to the early twentieth century, all in ten pages. Chapter 2 presents the “Theory of Underincome,” which is presented as an exchange game between two players: producers and merchants. Because of a coordination failure, it is possible that “income inertia” or “underincome” arises in equilibrium. Chapter 3 provides an account of the innovation process in American manufacturing, based on the electrification of the production process. It uses Ford Motor Company as an illustrative case of how the U.S. became industrialized by relying on EHTCFPT. This chapter also provides an account of the spread of electric power across several industries. Chapter 4 then moves to the core of his thesis arguing that the U.S. was suffering from “underincome” and that Congress’s first response was to increase protection. Chapter 5 extends this argument, and provides “a blow-by-blow account of the demise of the Smoot-Hawley Tariff Bill of 1929” and how the stock market reacted. Chapter 6 provides some details on the “Second Policy Response” ? the implementation of the National Industrial Recovery Act of 1933. In chapter 7, Beaudreau returns to the tariff issue, providing quantitative estimates of the amount of output gap. Beaudreau argues that the tariff was doomed to fail from the very beginning, as it was a policy response that was too weak, given the size of the output gap. Chapter 8 provides a brief summary and some concluding remarks.

In all honesty, it is very unlikely that readers will find Beaudreau’s argument to be persuasive. To begin with, the theory of “underincome” appears not to be all that different from a textbook description of a Keynesian-style slump in aggregate demand. Viewed from this perspective, Beaudreau’s “underincome” hypothesis is, at best, not new, at worst, very convoluted and hard to follow. Equally unconvincing is the suggestion that Republicans were responsible for the stock market crash of 1929 (as the title implies) because by October of that year, investors thought that the tariff bill was “as good as dead.” To make such a connection, at the very least, Beaudreau should have performed a formal event study, studying the behavior of stocks that were most exposed to the tariff bill, and compare it to the behavior of stocks immune to the implementation of the tariff.

This isn’t the first time that Beaudreau has made the claim that Republicans were somehow responsible for the stock market crash, or that too much technology was bad for the economy. A very similar argument is presented in his earlier book published in 1996. In fact, William Hausman reviewed Beaudreau’s 1996 book (Mass Production, the Stock Market Crash, and the Great Depression: The Macroeconomics of Electrification_, Westport, CT: Greenwood Press) for EH.NET in 1998 (see http://eh.net/bookreviews/library/0071). Unsurprisingly, it did not leave a very positive impression on him either.

Carlos D. Ramirez is Associate Professor of Economics at George Mason University. His major fields of research are banking and financial economic history. He has published banking and financial history articles in the Journal of Finance, Journal of Money, Credit, and Banking, Journal of Economic History, and Public Choice.

EH.NET BOOK REVIEW

Published by EH.NET (February 1998)

Bernard C. Beaudreau, Mass Production, the Stock Market Crash, and the Great Depression: The Macroeconomics of Electrification. Westport: Greenwood Press, 1996. xx + 182 pp. $59.95 (cloth), ISBN: 031329920X.

Reviewed for EH.NET by William J. Hausman, Department of Economics, College of William and Mary.

Beaudreau asserts boldly on the first page of his book that his purpose is to “provide a definitive account of the Great Depression and the events leading up to this cataclysmic event” (p. xv). At least he didn’t claim to have written “the” definitive account. In fact, this is a highly idiosyncratic treatment that explores a number of events of the ‘teens, 20s, and 30s. There is much that is outrageous, along with occasional insights that warrant further study. The fundamental argument is that productivity-enhancing structural changes in industry in the 1920s set the stage for the events that were to follow. The treatment of the period thus fits within the basic approach economic historians such as Michael Bernstein (The Great Depression: Delayed Recovery and Economic Change, 1929-1939, Cambridge University Press, 1987) and, more recently, Rick Szostak (Technological Innovation and the Great Depression, Westview Press, 1995) have taken.

The chain of logic is clearly defined but long. The electrification of industry (“the most important process innovation in this century”), because it set the process in motion, is actually the villain of the piece. The electrification of the assembly line in the 1920s (a process led by the Ford Motor Company) substantially raised productivity and led to an era of mass production. This brought conditions of “oversupply,” initially hidden by labor hoarding. Eventually, aggregate income failed to keep pace with productivity, not because profits rose substantially, but because wages failed to rise. By 1928 Senator Reed Smoot, with the support of Hoover, proposed restricting access to the U.S. market by raising tariffs. The prospect of passage of the tariff bill in 1928 set off the speculative stock market boom. The failure of the bill in the Senate the following year precipitated the stock market crash. Planned investment then was cut drastically, setting off the decline in income and the Great Depression. The National Industrial Recovery Act was the only policy response that had a chance of reversing the process, but this experiment in cooperative behavior aided by government was cut short by the Supreme Court. This is all laid out in the introduction. Twelve chapters, each of them short, then attempt to either flesh out the bare bones of the logic, or offer asides on some aspect of the historical process.

Because the chain of logic is long, it can be attacked at numerous points. Take, for example, the monocausal view of the course of the stock market. In two chapters and an appendix, Beaudreau links the prospects of the tariff bill as reported in the press to stock market activity. A correlation can be established, but the causality is obscure, relying heavily on an indirect link to planned business investment. One important aspect of the event that is not mentioned is the fact that industrial stocks actually rose much less than public utility stocks, especially stocks of public utility holding companies, a sector not much affected by the prospective tariff. In the end the correlation is not sufficient to prove the point.

The book contains some interesting chapters. In one, a game-theoretic model is used to show how an economy may get stuck in a low-growth equilibrium in the presence of a productivity-enhancing technological shock. It carries some heavy assumptions, the critical one being that firms will not raise wages in response to the shock (without some third-party intervention). It is conceivable that such a process had a role to play in bringing on the depression.

This book is not a definitive account of the events surrounding the Great Depression. The basic approach of exploring structural changes as the root cause of the depression is, however, a worthy endeavor. Perhaps if the author had been more modest in his claims, my reaction would not have been as critical.

William J. Hausman Department of Economics College of William and Mary

Will Hausman is the author of “Long-term Trends in Energy Prices,” in Julian L. Simon, ed., The State of Humanity, Oxford: Blackwell Publishers, 1995, and other papers on the history of the U.S. electric utility industry.

?

Published by EH.NET (April 2003)

Didier Sornette, Why Stock Markets Crash: Critical Events in Complex

Financial Systems. Princeton, NJ: Princeton University Press, 2002. xx +

421 pp. $29.95 (hardcover), ISBN: 0-691-09630-9.

Reviewed for EH.NET by Gary Santoni, Department of Economics, Ball State

University.

Why Stock Markets Crash by Didier Sornette is an interesting and

thought-provoking book. Sornette is a professor of geophysics at the University

of California, Los Angeles who specializes in the scientific prediction of

catastrophes. Since stock market crashes are, without question, catastrophes,

the reader might expect an informative treatment of the relationship between

catastrophes that occur in the natural world and those that occur in financial

markets. Sornette’s discussion of the science of earthquakes, volcanic

eruptions, hurricanes, tornadoes and meteorite impacts is riveting. In

addition, the reader learns about how such notions as finite-time

singularities, log periodic oscillations, Cantor sets, fractal dimensions,

Schrodinger’s equation and log-quasi-periodicity, are used to characterize and

predict these natural disasters. Readers interested in why stock markets crash

and the relationship between these events and natural catastrophes will be

disappointed, however.

Clearly, natural and financial phenomena are similar in that catastrophes occur

in both. It is something else to argue that the processes leading to these

events and the relevant tools of analysis are the same or even similar. George

Stigler once noted that the economist faces a level of difficulty not shared by

the physical scientist. The economist’s “main elements of analysis are people.

… Imagine the problems of a chemist if he had to deal with molecules of

oxygen, each of which was somewhat interested in whether it was joined in

chemical bond to hydrogen. Some would hurry him along; others would cry shrilly

for a federal program to drill wells for water instead; and several would

blandly assure him that they were molecules of argon.”1 None of this is meant

to suggest that the scientific method has no place in the study of economics.

Few economists did more than Stigler to promote the application of science in

economics but he warns that the economist can expect to encounter some special

problems.

Sornette bumps up against one of these special problems in his discussion of

the fundamentals of stock prices. He argues that, “These considerations make it

clear that it is the expectation of future earnings and future capital

gains rather than present economic reality that motivates the average investor,

thus creating a speculative bubble” (p. 270). Sornette fails to recognize that

stock prices (or, more precisely, the choices people make in determining these

prices) are always based on expectations regarding the future — and

this implies nothing about whether or not they contain a speculative bubble.

Irving Fisher said it best when he noted that, “Our present acts must be

controlled by the future, not as it actually is, but as it appears to us

through the veil of chance.”2 Decisions regarding stocks are no exception.

Expected future cash flows (dividends, capital gains, etc.) are the

important fundamentals of prices — they are the economic reality. Present

earnings, Sornette’s reality, are only relevant in so far as they contain

information about the future. The behavior of people, unlike molecules of

oxygen, is driven by expectations.

The most enlightening discussion in Sornette’s book is his treatment of the

efficient markets hypothesis in Chapters 2 and 3. This hypothesis implies that

stock prices move at a random walk so that changes in the price are

unpredictable. Since crashes are simply large negative changes in price, the

hypothesis implies that crashes cannot be predicted. While the evidence that

has accumulated over the years is largely consistent with this idea, an

interesting exception to this general result is noted in Chapter 3. Examining

daily data on the Dow Jones Industrial Average over the last century, Sornette

finds 14 episodes — a total of 64 trading days out of a sample of about 25,000

— that violate the implications of the hypothesis. These unusual observations

are all associated with large declines in stock prices ranging from -12.4% to

-30.7% (p. 61). The conclusion to be drawn from this is that stock prices

behave unusually (in the sense that successive changes in them may be related

and, hence, predictable) during episodes of large price declines.

There are several points that are important here. These unusual episodes only

occur during periods of large price declines. Second, there are relatively few

of them — 64 of 25,000 trading days. Third, the average length of these 14

episodes is only 4.5 days so the period over which prediction may be possible

is of short duration. Finally, these periods are only detectable after

prices have begun to decline. For the vast bulk of the evidence Sornette

analyzes (particularly, when prices are generally rising), changes in stock

prices behave randomly and, thus, are unpredictable.

Perhaps because of the confusion regarding the role of expectations in economic

decision-making, Sornette ignores the efficient market hypothesis and the

evidence regarding it in the remainder of his book and focuses instead on

various bubble models of stock prices all of which imply that prices behave

unusually before a crash, i.e., while prices are generally rising. In

this regard, the reader is treated to discussions of the Ising Model of

Cooperative Behavior, El-Farol’s Bar Problem, Mimetic Contagion and the Urn

Model, and Herd Behavior and Crowd Effects to name a few. Sornette models the

bubble with an equation containing a log-periodic correction to a power law for

a variable (stock prices) exhibiting a finite-time singularity. In short,

Sornette attempts to fit a trend to stock prices for periods prior to crashes

even though the data analyzed in Chapter 3 suggest that no such trend exists.

As might be expected, the results are disappointing even though the test

periods selected are those immediately preceding 1929 and 1987, the two largest

crashes on record. The statistic measuring the equation’s goodness of fit

varies erratically as the sample period prior to the crash is varied and shows

a marked improvement only when data subsequent to the crash are included. Thus,

the model “predicts” the crash only after it has occurred (pp. 330-34).

Sornette indicates that this is an “idiosyncrasy” of the model, which, of

course, calls into question its relevance for both theory and practice.

People will always be interested in stock market crashes. If they were

understood, it might be possible to forecast them which, of course, could lead

to vast riches. I wish Sornette good luck in his endeavor. Should he be

successful, I don’t expect he will tell us about it, however.

Endnotes: 1. George Stigler, The Theory of Price, Macmillan Company,

1966, p. 8. 2. Irving Fisher, The Rate of Interest, Macmillan Company,

1907, p. 213.

Gary Santoni’s recent publications include “Expected Dividend Growth,

Valuation Ratios and Rational Optimism,” in the Journal of Financial and

Economic Practice (Fall, 2002).

Published by EH.Net (September 2017)

Phillip G. Payne, Crash! How the Economic Boom and Bust of the 1920s Worked. Baltimore: Johns Hopkins University Press, 2015. viii +142 pp. $20 (paperback), ISBN: 978-1-4214-1856-8.

Reviewed for EH.Net by Randall Parker, Department of Economics, East Carolina University.

Crash! is a part of the “How Things Worked” series being published by Johns Hopkins University Press. The list of books included in this series is not particularly long (at least not yet) and includes books on Ellis Island, sod busting, and Union Army recruitment of U.S. colored troops, among other topics. I like the idea behind this series, and the editors have really done themselves proud by having Phillip Payne author this book on the boom and bust of the 1920s. It is the first entry in the series pertaining to economic history.

Payne is a professor of history at St. Bonaventure University. If the idea behind the “How Things Worked” series is to produce non-technical books that provide useful road maps that hit the high points of historical epochs and give undergraduates the fundamental knowledge they need to understand the basics of what went on and why, then Crash! accomplishes what it sets out to do. Payne provides an in-depth look at the 1920s and the emergence of speculation and how the culture and economy of the time promoted that unhealthy trait (that still afflicts us today and ever shall). All the usual suspects and their stories are told: James Riordan and Ivar Kreuger (and others who did themselves in), Richard Whitney and his attempt to save U.S. Steel share prices, J.P. Morgan and others. The roles they played in bringing about the unfortunate events of 1929 and the beginning of the Depression with the stock market crash are described with historical elegance and come alive in the words of Payne. The level of detail of the events and the actors that made them happen represent a new and fresh look at a familiar, and certainly guilty, culprit in helping to bring about the Great Depression.

The last thirty pages of the book are also a road map for the essential elements of the recovery from the Depression, the emergence and governance of Franklin Roosevelt and the New Deal, plus an Epilogue comparing the 1920s to the malaise we endured in 2008. Correctly saying “How This Time Is (Not) Different,” we are reminded that this pattern will almost certainly repeat sometime down the road.

There are some particularly enlightening parts of the book. The West Virginia Coal Wars in the early 1920s and the use of air power against American civilians is not something economists hear much about. But the shock I felt when I read about it cannot be overstated. Moreover, I had forgotten that Herbert Hoover blamed World War I for the Great Depression. Payne reminds us that it was not Peter Temin who originally made this connection, although Temin did it for the right reasons and blamed the establishment of the interwar gold standard in a changed world in which the gold standard no longer functioned well and was an agent of deflation and depression.

There are several spots where the economics of the era are just briefly mentioned and not discussed much. There is no mention of the major debate of whether there was a bubble in stocks or not in the 1920s. This is far from clear from the literature — and my judgment is that it never will be decided. Alas, there is only one sentence mentioning that both Irving Fisher and John Maynard Keynes thought stock prices would continue to grow and both lost their fortunes. Moreover, there is no discussion of how deflation and the gold standard were linked. The recession of 1920-21 is blamed on deflation with no mention of this necessity for the re-establishment of a gold-backed currency at antebellum prices. But I do not wish to overstate the case. Payne does what he sets out to do and he is to be credited for such a readable book (indeed I read it twice!).

There is one matter, however, that cannot be unmentioned. I joined this club many years ago when James Hamilton showed me the error of my ways in a working paper I had sent him. It is a club to which Phillip Payne now belongs — and he should delight in being a part of this club as the membership list is long . . . and now we have one more. In four different places, he refers to “the Bank of the United States.” Well, it is really “the Bank of United States,” there is no “the” between “of” and “United.” Welcome to the club Professor Payne. And thanks for this very useful historical description of the bumpy road during the interwar period.

 
Randall Parker is editor of The Seminal Works of the Great Depression (Edward Elgar, 2011) and co-editor (with Robert Whaples) of The Handbook of Modern Economic History and The Handbook of Major Events in Economic History (both from Routledge, 2013).

Copyright (c) 2017 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (September 2017). All EH.Net reviews are archived at http://www.eh.net/BookReview.

Published by EH.Net (August 2015)

Ali Kabiri, The Great Crash of 1929: A Reconciliation of Theory and Evidence. Basingstoke, UK: Palgrave Macmillan, 2014. xv + 236 pp. $115 (hardcover), ISBN: 978-1-137-37288-8.

Reviewed for EH.Net by Raphaël Hekimian, West Paris University and the Paris School of Economics, and David Le Bris, KEDGE Business School.

The New York Stock Exchange (NYSE) crash in 1929, which featured a 45 percent decline in stock prices over the last weeks of October, is one of the most studied topics in financial history, and academic researchers still fiercely debate many of its aspects. Among those, we can cite the crucial question of whether or not the stock market boom of the 1920s was justified by fundamental values. The Great Crash of 1929: A Reconciliation of Theory and Evidence aims at resolving this issue: could the rise in stock prices before the crash be seen as an asset “bubble,” and if so, could it have been anticipated?

Ali Kabiri relies on both contemporaries (Smith 1924) and more recent academic research (Shiller 1981, 2000; Goetzmann and Ibbotson 2006) to provide extensive and detailed empirical analysis. After checking some of their results with new hand-collected data, the book details a range of econometric tests and robustness checks in order to rigorously analyze ex ante and ex post stock prices movements between 1921 and 1932.

The book is organized into six chapters. After an introduction, chapter two reviews the modern literature on the financial history of the 1920s, the different types of tests used in this literature, the theory of asset “bubbles,” and the Efficiency Market Hypothesis (EMH).

Chapter 3 focuses on the historical background of the U.S. economy, providing a detailed look at debt levels in various economic sectors, in particular the housing debt held within the banking sector. In addition, Kabiri considers the Gold Standard system and the newly formed Federal Reserve and its interest rate policy, and the effect of credit expansion on U.S. corporate earnings and stock prices. The chapter ends with a look at productivity growth and expected inflation as drivers of the valuation of assets. The main results are that the first part of the boom (1921-1927) can be attributed to a credit/debt expansion coming from World War I monetary base expansion, along with an expectation of higher returns or lower risk premia on U.S. common stocks.

The fourth chapter looks at the dynamics of U.S. common stock prices from 1870 up to 2010. The author tests market efficiency with a long-term asset prices perspective, using historical data to observe both ex ante expectations and ex post realizations of stocks returns. The objective here is to test for a potential deviation from rational valuation during the second part of the boom (1927-1929) in three ways. First, at the aggregate level: the author estimates the scale of the overvaluation of stocks in September 1929. In order to replicate the 1920’s investors’ expectations, he applies a method of that time (Smith, 1924) to a set of common stocks of large firms between 1900 and 1929 to calculate the dividend growth rate; accepting the hypothesis that expectations of that time were formed according to financial theories of that time. The historical Equity Risk Premium (ERP) before 1927, taken from both recent (Goetzmann and Ibbotson 2006) and contemporary (Smith 1924) research, is used as a discount rate to solve a Dividend Discount Model. This market valuation is then compared to the actual level reached in 1929, so as to estimate the scale of the overvaluation, following the basic method of Schiller (1981). According to this method, the estimated overvaluation of U.S. common stocks is found to revolve around 50 percent. Secondly, an ex post analysis of the very long-run realized returns is run. The aim is to test if investors could have anticipated an upcoming growth in dividends in 1927, before the second phase of the boom. To do so, the author constructs a total return index (cautiously avoiding the survivorship bias) using data from 1925 up to 2010. This return is then compared with real returns of government bonds to deduct a realized equity premium, which is found to be similar to the historical ERP calculated in Smith (1924). According to the author, this indicates that high returns were not forthcoming on stocks when compared to historical figures, so perfect foresight should have prevented rational investors from expecting a higher dividend growth rate in the late 1920’s. Finally, the aviation industry, a technological sector potentially prone to overvaluation in the 1920s, is tested using a valuation model available in the Moody’s Manual of Investments (1930). The model is calibrated with historical data from 1904 to 1929 of the automobile industry’s growth path. This test implies that aviation stocks were overvalued in 1929 by around 300 percent, relative to the history of the automobile industry. It means that a rational investor in 1929 would not have held those stocks in his portfolio.

Chapter 5 investigates the role of the money market in the boom and bust of the NYSE. It is known that the Federal Reserve took measures to slow down speculation by restraining credit to banks and funds under regulation. The author argues that a sort of ‘shadow banking system” had been developing to lend to traders, as a regulatory arbitrage. Funds were coming mostly from U.S. unrestricted corporations, but also investment funds and foreign banks. In order to assess whether the crash was due to an exogenous shock stemming from a credit retraction of those unregulated sources, tests of the ratio of stock prices to credit are run. Data show that the crash was not induced by a credit contraction even if regulation arbitrage generated instability. The results are more in favor of a bubble reversal in stock prices.

Finally, chapter 6 studies stock prices movements with regards to their fundamental values but during the 1929-1932 period. According to the data, it seems as if an undervaluation occurred during the Great Contraction based on ex post analysis. The conclusion is that the low level of the market in 1932 cannot be fully explained by rational forecasts, meaning that irrational pessimism probably took place.

Ali Kabiri’s book provides a synthesis of the debates on the 1929 crash but also a new set of tests built on both existing and newly collected data to understand which forces drove the stock market to levels reached in the 1920s, based on both ex-ante and ex-post analysis. In financial history, the book provides new insights on how investors could have valued stocks with respect to available information and, this is an important hypothesis, methods at the time.  He also finds evidence of the deviation in prices based on ex post fundamental values. In addition, the book contributes to behavioral economics, estimating the rationality of the rise and fall in stock prices during the boom and bust as well as to history of economic thought, detailing financial theories and methods of the 1920s.

Raphaël Hekimian is a Ph.D. student at the West Paris University and the Paris School of Economics. He is also research assistant for DFIH, a database project collecting and keying financial historical data on the Paris Stock Exchange. David Le Bris is an assistant professor at KEDGE Business School. He has written several articles about the history of the French financial market. Using daily data, they work together examining the absence of any contagion of the 1929 U.S. crash to the French stock market.

Copyright (c) 2015 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (August 2015). All EH.Net reviews are archived at http://eh.net/book-reviews/

Published by EH.Net (March 2014)

William N. Goetzmann, Catherine Labio, K. Geert Rouwenhorst and Timothy G. Young, editors, The Great Mirror of Folly: Finance, Culture and the Crash of 1720. New Haven: Yale University Press, 2013. xiv + 346 pp. $75 (hardcover), ISBN: 978-0-300-16246-2.

Reviewed for EH.Net by Antoin E. Murphy, Department of Economics, Trinity College Dublin.

This is a wonderful book about an extraordinary work, Het Groote Tafereel der Dwaasheid (The Great Mirror of Folly), which though a bibliographic nightmare, provides a fascinating set of engravings and texts about the world’s first stock market booms and collapses in Paris, London and Amsterdam during the frenzied financial year of 1720. Yale University is to be congratulated not only for publishing such a book through Yale University Press, but, also because two of its libraries, the Beinecke Rare Book and Manuscripts Library and the Lewis Walpole Library, have against the current, been presciently building up a financial history collection that provides many of the antiquarian treasures that are presented in this volume.

When the financial crisis broke in 2007 and 2008 many economists who had forgotten about history, naively believing that the Great Moderation had been reached, found themselves on intellectual quicksand. Despite all their apparently sophisticated theorizing they were unable, excepting for a small number of economists including the foreword writer of this book, Nobel laureate Robert J. Schiller, to cast very much light on the unfolding events which destroyed a great part of the financial fabric of the United States and, via contagion effects, nearly brought down the global economy. History had been replaced by mathematical modelling; antiquarian books had been discarded and libraries holding them downgraded; the past was seen as no predictor of the future. But of course history does have a tendency to repeat itself. Remove the wigs from the eighteenth century bankers, financiers and traders and replace them with mobile phones and one finds essentially the same type of agents with all their excessive hype that characterized recent financial markets not just in New York but across the globe. The Great Mirror of Folly of the eighteenth century has most certainly been mirrored in the follies at the start of the twenty-first century. If one accepts this view then there are still important roles for antiquarian books, specialist libraries, economic historians and historians of economic thought to highlight how apparently rational people become irrational, inhabiting asset market bubbles that have huge economic and social costs when they burst. So take a bow Yale along with the editorial team that published this book.

The Tafereel, which aimed at providing “a warning for future generations,” was first published in 1720. From a bibliographic perspective it is an enigma because no two copies of it are alike. The printers appear to have had a portfolio of as many as 85 engravings along with attendant plays, poems, proposals for bubble companies, etc., from which to select the composition of each volume. Kuniko Forrer’s remarkably detailed bibliographical interpretation explains that though “we may well compare the Tafereel to a kit that readers were expected to put together by following instructions for use,” in fact “purchasers were free to organize the volume as they chose” (p. 35). Though this volume presents what the editors describe as the “ideal” Tafereel of 74 plates, I feel this decision, perhaps taken on economic grounds, is somewhat disappointing because it necessarily means that not all the plates figuring in some issues of the Tafereel appear. That said, in its very first publication the Tafereel contained only 35 plates

The plates provide its readers with, as Frans de Bruyn, points out a surreal world of “dreamscapes populated with fantastic creatures, mythological characters, hunchback harlequins, devils, dwarves, monkeys, and lizard like reptiles” (p. 21). Hot air, stoked by bellows, and leading to the creation of bubbles abounds in many of the plates. The work is a giant piece of satire aimed at denigrating the greed and hubris of the speculators of 1720. It is easy, of course, ex post to satirize the events of 1719 and 1720 in this way after the bubbles had burst – the first Tafereel was published in late 1720. However, this is to do an injustice to John Law and the Mississippi System. Law was extraordinarily modern and innovative, believing that it was possible to replace specie money with paper money and to create a private sector company capable of managing both the national debt and at the same time developing colonial territories, particularly those in North America.  His vision of a specie-less society would ultimately become the norm in the twentieth century and his attempts at financial innovation served to show how lateral thinking on this front could change society. Rik Frehen, William Goetzmann and Geert Rouwenhorst point out in chapter 4 that though the democratization of capital that suddenly appeared in 1720 was quickly satirized by the literati of the day, “these equity booms were the clear forerunners of future capital markets” and that “ultimately the world’s stock markets re-emerged to provide widespread public access to investment in business enterprise” (p. 84).  Consistent with this line, Eugene White, in a thoughtful re-assessment of Law, asks the question as to whether modern scholars who have re-assessed Law as a great theorist, modernizer and macroeconomist “might be justified in tagging the Dutch volume a scurrilous eighteenth-century blog that defamed John Law and his scheme to liberate France from the shackles of the ancien régime finance” (p. 114).

This is a book of great scholarship and one that should adorn the shelves of all those interested in money, banking, financial innovation, bubbles and the behavior of people during asset market crashes.  At $75 it is a steal and could over the years appreciate at a faster rate than many of today’s banking shares!

Antoin E. Murphy is the author of numerous books and articles, including John Law: Economic Theorist and Policymaker (Oxford University Press, 1997).

Copyright (c) 2014 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (March 2014). All EH.Net reviews are archived at http://www.eh.net/BookReview

Published by EH.Net (July 2013)
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Janice M. Traflet, A Nation of Small Shareholders: Marketing Wall Street after World War II. Baltimore: Johns Hopkins University Press, 2013. xi + 242 pp. $45 (hardcover), ISBN: 978-1-4214-0902-3.

Reviewed for EH.Net by Lynne Pierson Doti, School of Business and Economics, Chapman University

Don?t let the frivolous dust jacket fool you. While A Nation of Small Shareholders is very readable, it represents some very serious scholarship. Janice Traflet is a bona fide historian and an excellent writer. Moreover, as an associate professor in the School of Management at Bucknell University, she has a strong understanding about how a financial business operates. With this perspective, she has produced a unique history of how the New York Stock Exchange marketed equities to the consumer, especially in the 1950s and 1960s.

After World War II, the New York Stock Exchange (NYSE) and the average household had ambivalent attitudes about each other.? The NYSE watched covetously as consumer income rose and households invested heavily in bonds, life insurance and homes.? However, a JP Morgan partner Thomas Lamont represented the attitudes of many market experts when he blamed the 1929 crash on these investors of moderate means (as he put it, ?every Tom, Dick and Harry?) and hoped these people would not be in the market in the future. It was also true that the average household remembered the shadow of 1929 and preferred safer, more accessible and better marketed investments to shares of stock.

After the 1930s though, tightened regulations, particularly by the Securities and Exchange Commission (SEC), a reorganization of the NYSE board, and the rising number and reputation of companies listed on the NYSE made even average-income consumers feel that stocks could be a safe investment.? About that time, a few brokerage houses began marketing stocks to the ?small investor.? Those brokerage firms who were members of the NYSE were mildly encouraged to make these appeals ?as long as advertisements were truthful and in good taste? (p. 41).

Charles Merrill was a leader in marketing stocks and had a conservative reputation stemming from his 1928 warnings to clients to reduce their risk. In 1940, his brokerage firm began an advertising campaign directed toward potential clients with modest amounts of investment funds. The firm would become a leader in this type of marketing in the 1950s, not only advertising in print, but also offering investment seminars and information booths to educate their customers.

Some of the earlier Merrill ads explained how a stock exchange encouraged the operation of a free market. The NYSE discussed starting a similar campaign, but found the members would not financially support it. However, when G. Keith Funston became the new president of the NYSE in 1951, he made it clear that the board would be engaged in marketing. Serving the NYSE until 1967, he established the advertising theme as soon as he decorated his office with a picture of Independence Hall. Buying stocks listed on the NYSE was investing in America. He said the NYSE was the ?epitome of free enterprise? (p. 73). A few years later, Funston started a department to coordinate the marketing efforts of industry and trade associations, companies listed on the NYSE and institutions that invested in those companies. The NYSE?s own slogan became ?Own Your Share of American Business.? The campaign to make stock ownership synonymous with patriotism and anti-communism was soon prevalent in many advertisements. A rising stock market in 1953 and 1954 also helped boost stock ownership.

There was still a problem attracting investors with limited funds. Commissions were dependent on the size of the order. The NYSE and some brokerage firms developed a monthly investment plan (MIP) to allow customers to commit to paying a monthly sum for a set period. Rather than saving up for a ?round lot? of 100 shares, the customer would gain ownership of the shares as they paid for them. As the price of the stock fluctuated, each monthly payment earned more or less shares. This was a solid plan for investors who only wanted to buy stock in one or a few companies, but mutual funds offered greater portfolio diversification and experienced very strong growth in the 1950s. ?In 1940, less than 300,000 mutual fund accounts existed. By 1955, the number of mutual fund accounts had ballooned to more than two million? (p. 105). This was in spite of the fact that mutual funds were still not allowed to advertise (but did sell door-to-door!).

In the mid-1950s, the NYSE established a department for public education. The department coordinated free speakers and produced brochures for consumers. By the 1960s the exchange provided thousands of lectures a year in libraries, service clubs and other venues that would attract the smaller investments.

The NYSE would be substantially changed in the 1960s and 1970s. An increase in the importance of institutional trading of securities resulted from consumers investments in mutual funds, pension funds and life insurance. For the exchange, the focus turned from marketing to operating efficiency.

The 1980s saw the beginning of the long bull market and the end of fixed commissions. With the end of fixed commissions and the internet came e-trading by small investors. The story comes full circle, from overcoming consumer fear of the equity market in the post war period to the 2001-2002 declines in the market, which once again created fear among small investors.

The focus of this book is on the NYSE and its experiences attracting the average consumer into stock investment, in the post-war period. However, as such it adds an important piece to the literature on the history of the American equity market. Financial historians like Robert Sobel (The Big Board: A History of the New York Stock Market) or Charles Geisst (100 Years of Wall Street) will benefit greatly by this meticulous research. The book will also be interesting to general business historians and to marketing students, academics and business professionals.

Lynne Pierson Doti is the David and Sandra Stone Professor of Economics at the Argyros School of Business and Economics, Chapman University. She is currently working on a book on the history of real estate financing in California. ldoti@chapman.edu.

Copyright (c) 2013 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (July 2013). All EH.Net reviews are archived at http://www.eh.net/BookReview

Published by EH.NET (October 2011)

Michael Perino, The Hellhound of Wall Street: How Ferdinand Pecora?s Investigation of the Great Crash Forever Changed American Finance. New York: Penguin Press, 2010. ix + 341 pp. $28 (hardcover), ISBN: 978-1-59420-272-8.

Reviewed for EH.NET by Carlos D. Ramirez, Department of Economics, George Mason University.

Between 1929 and 1933 the U.S. economy endured the largest contraction in history. Real GNP fell by more than a quarter, the stock market collapsed, unemployment reached a staggering 25 percent, the banking sector was decimated, and panics were the order of the day. People lost a lot of money, faith in the system, and for many, even hope. It was inevitable that such a cataclysmic scenario would result in a large public outcry demanding politicians to do something. Congress?s reaction was to follow the Hollywood-style legislative process: quickly identify the ?villains,? condemn them, and then politically execute them. In the process, congressmen enacted legislation, thereby becoming the ?heroes? who saved the day, and everyone lived happily ever after.

At the time, it was the Wall Street bankers who got to play the role of villains. These ?banksters? ostensibly followed practices that ultimately caused the collapse of the banking system. Such was the political theater within which Ferdinand Pecora operated. Pecora was a Sicilian-born lawyer that Senator Peter Norbeck (R-South Dakota) had selected to become Chief Counsel of the U.S. Senate Committee on Banking and Currency on January 22, 1933.? Pecora?s mission was to investigate the so-called corrupt Wall Street banking practices that were seen as being largely responsible to the economic calamity of the period. His first and probably most important target was Charles Mitchell, then Chief Executive of National City, the bank with the largest network of bond and securities dealings. Michael Perino?s book provides a detailed account of how Pecora uncovered the ?evils? and ?abuses? that that Mitchell had committed. Largely through Pecora?s hearings, the public?s perception of bankers dramatically shifted, making them look like the scum of the earth for their unlimited ?greed,? ?arrogance,? and ?unscrupulous? behavior.

Perino?s book is well written — it is engaging and entertaining. However, he ends up idealizing Pecora and demonizing Mitchell. This is very unfortunate, because by exalting Pecora?s view of the world, Perino panders to the now discredited theory that bankers somehow caused the Depression. (Even if Pecora did not intend to make this causal inference, it was largely interpreted as such.) Back then, the bankers were held responsible for the economic ills of the period because they had not stuck to the sound practices of the ?real bills? doctrine — that bank lending should be limited to short term, self-liquidating loans (Huertas and Silverman, 1986, p. 88). Had they stuck to that model, by implication, the excesses of the 1920s would not have happened, and maybe even the economic calamity of the 1930s could have been avoided.

That Progressive interpretation of the events is now largely defunct. Take, for example, the allegation that ?stock pools? were used to manipulate stocks. Indeed, this allegation was one of the primary motivations for the creation of the Securities Exchange Act of 1934. But the research of Jiang, Mahoney, and Mei (2005) finds no evidence that these pools affected stock prices in the long run, or that they adversely affected small investors.

Perino claims that Pecora wanted to show ?all the reckless, inappropriate, and imprudent actions that Mitchell and others at City Bank had taken, but he always treated Mitchell and his ilk as prime examples of what was wrong in commercial and investment banking. … Mitchell was not an aberration; he was representative of bankers as a class.? (p. 221) The implication is, of course, that bankers allegedly abused their depositors? trust by underwriting securities of poor quality. But Puri (1994) shows the exact opposite occurred: ?The evidence shows that, contrary to conventional wisdom, bank underwritten issues defaulted less than non-bank underwritten issues, over a seven year period from the issue date, and had a significantly lower mortality rate.? Kroszner and Rajan (1994) arrive at a similar conclusion. They find that the failure rate of bonds originated and placed through bank affiliates was no higher than that of bonds placed through investment banking syndicates. This research, unfortunately, is not cited.
What about the claim that bank involvement in the business of underwriting securities was somehow responsible for the decimation of the banking system? Once again, the evidence does not support it. White (1986), for instance, finds that the failure rate for all national banks in the 1930-33 period was 26.3%. However, the failure rate of national banks that were also involved in the securities business was only 7.2%. Hence it is hard to argue that the involvement of banks in the securities business is responsible for the high failure rate of banks during that period.

Indeed, modern research has gone as far as to question the evidence that the hearings supposedly uncovered. Benston (1990) argues that the investigation did not reveal any credible evidence of the alleged abuses. Like Perino, he meticulously examines the congressional hearings? ?evidence? uncovered by Pecora, but arrives at a different conclusion than Perino. Benston finds that the hearings were largely biased in favor of the preconceived ideas of Senator Carter Glass (who introduced the provision for the separation of investment banking from commercial banking). Witnesses were purposely and strategically chosen, and the questioning was entirely one-sided, with no chance for rebuttals. Huertas and Silverman?s (1986) revisionist essay argues that Mitchell was in fact made a scapegoat of the stock market crash of 1929, something that, to be fair, Perino notes.

It seems that the image of Mitchell as an unscrupulous, tax-evading banker was in reality purposely created by Pecora in order to cement enough political support to enact the far-reaching New Deal reforms of the 1930s.

References:

Benston, George J., 1990, The Separation of Commercial and Investment Banking: The Glass-Steagall Act Revisited and Reconsidered, New York: Oxford University Press.

Huertas, Thomas F. and Joan L. Silverman, 1986, ?Charles E. Mitchell: Scapegoat of the Crash?? Business History Review, 60: 81-103.

Jiang, Guolin, Paul G. Mahoney, and Jianping Mei, 2005, ?Market Manipulation: A Comprehensive Study of Stock Pools,? Journal of Financial Economics, 77: 147-70.

Kroszner, Randall S. and Raghuram G. Rajan, 1994, ?Is the Glass-Steagall Act Justified? A Study of the U.S. Experience with Universal Banking before 1933,? American Economic Review, 84: 810-32.

Puri, Manju, 1994, ?The Long-term Default Performance of Bank Underwritten Securities Issues,? Journal of Banking and Finance, 18: 397-418.

White, Eugene, 1986, ?Before the Glass-Steagall Act: An Analysis of the Investment Banking Activities of National Banks,? Explorations in Economic History, 23: 33-55.

Carlos D. Ramirez is Associate Professor of Economics at George Mason University. His major fields of research are banking and financial economic history. He has published banking and financial history articles in the Journal of Finance, Journal of Money, Credit, and Banking, Journal of Economic History, and Public Choice.

Copyright (c) 2011 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (October 2011). All EH.Net reviews are archived at http://www.eh.net/BookReview.

Published by EH.NET (July 2007)

Roger W. Spencer and John H. Huston, The Federal Reserve and the Bull Markets: From Benjamin Strong to Alan Greenspan. Lewiston, NY: Edwin Mellen Press, 2006. x + 251 pp. $110 (cloth), ISBN: 0-7734-5784-3.

Reviewed for EH.NET by Gary J. Santoni, Department of Economics, Ball State University.

This book by Roger Spencer and John Huston examines the relationship of Federal Reserve policy to stock market activity by focusing on the monetary policy responses of Benjamin Strong, William McChesney Martin Jr. and Alan Greenspan to the three major bull markets that occurred during their respective tenures as leaders of the Federal Reserve. The authors devote three chapters to discussions of each of these Fed officials and the bull markets they struggled with. A fourth chapter presents an empirical evaluation of the Fed’s policy response to heated stock market activity.

This is an interesting book. It begins with a very informative discussion of the relationship between the twelve district Federal Reserve Banks (particularly, the New York district bank), the Washington Federal Reserve Board and the U.S. Treasury during the Fed’s formative years. It discusses the various roles played by Carter Glass as author of the legislation that formed the Fed and his service as Secretary of the Treasury and (at the same time) member of the Washington Federal Reserve Board. The discussion presents a rather detailed account of the clashes of personalities and the different views of Glass, Strong (president of the New York Fed) and William Harding (president of the Washington Board) regarding Fed independence, the appropriate tools of policy, their application and, in particular, the role of the Fed in controlling speculative activity in the stock market. The discussion is lively and extensive excerpts from personal letters give the reader a real feel for the personalities and motives of the main characters.

A particularly illuminating example of the above is found in an excerpt from a letter to Senator Elihu Root from Benjamin Strong. In it Strong observes, “In their great desire to lay all of the troubles and fancied troubles of this country to the New York Stock Exchange, some of our legislators go to such length that it makes it difficult to decide where ignorance leaves off and willful misunderstanding begins.” I suspect there are relatively few present day Fed officials who come away from a Congressional hearing without similar thoughts. Financial arrangements and markets have evolved considerably since 1914 but the changes have apparently done little to alter the strife between these markets and some of those who occupy the political arena.

While this book studies the influence of stock market activity on the policy actions implemented by the Federal Reserve, the authors point out that each of their three principle characters (Strong, Martin and Greenspan) believed the Fed’s policy instruments to be ill suited to regulating prices in equity markets. Greenspan, for example, argued that the Fed can only check a bull market by rationing “credit severely enough to paralyze business itself.” Strong’s view was similar suggesting that if the Fed forced interest rates up to curb speculation it could penalize the entire country by slowing economic growth. Consequently, it may be better to simply allow speculators to suffer the ultimate consequences of their own excesses. To do otherwise, according to Strong, would result in a degeneration of Fed policy actions to those of “regulating the affairs of gamblers.”

Greenspan went even further in his critique of the use of monetary policy to curb speculative activity in a frothy market. Not only are the Fed’s tools too blunt to stem this activity without having unintended consequences, it is difficult to identify bubbles before they crash. Greenspan suggested that, “There is a fundamental problem with market intervention (on the part of the Fed). It presumes that you know more than the market. … This raises some fascinating questions about what our authority is and who makes the judgment that there actually is a bubble.” Later, in a speech given in 1996, he asked, “But how would we know when irrational exuberance has unduly escalated asset values …” (emphasis added).

Despite their reservations, each of the three attempted to tame the bull markets that arose during their tenures. Each failed. The markets crashed and the monetary policies that were intended to prick the bubbles contributed to the following decline in business activity in general.

The book does not tell us why these Fed leaders ignored their better instincts to become involved in attempts to regulate stock prices. That is disappointing. In fairness, Spencer and Huston do not completely buy the argument regarding the difficulty in detecting bubbles in equity prices, so, perhaps, they are more willing to accept the Fed’s intervention in these instances without question.

On the whole, this is a very enjoyable and informative book. I recommend it to those interested in the evolution of Fed independence, the development of its policy tools, and particularly, the role of the Fed in controlling speculative activity in the stock market.

Gary Santoni is an Emeritus Professor of Economics at Ball State University. His recent research is on federal regulation of securities markets and stock returns.